What will it take to get stocks moving again?

Eight months into the year, the S&P 500 is up 2.37% and the NASDAQ is down 6.58%.  From January 2005, which marked the end of the last decent rally, the S&P 500 has gained 7.4%, which is about the same return as an investment in bank CD’s over the same time frame.  Earnings for the S&P 500, however, have once again surprised to the upside.  The forecast in June was that earnings would drop below 10% for the first time in 16 quarters at 9.1%.  With 86% of S&P 500 companies reporting, earnings growth has averaged 13.4%.  What will it take to get stocks moving again?

Fed Policy

For the past two years, much of our commentary has focused on Federal Reserve Bank policy.  Stocks don’t do well when the Fed is raising interest rates, because investors apply a higher discount factor to future earnings.  At the height of the dot.com madness, the P/E ration on the S&P 500 was 44.  In 2003, the ratio fell to 20.3, 17.9 in 2004, 16.3 in 2005, and is projected at 14.8 for the full year 2006, which is a level not seen since 1991.

On Tuesday, the Fed announced no rate change after 17 consecutive 25BP increases from 1% to 5.25%, citing a slowing housing market, and the adverse effects of higher energy costs and interest rates on consumer spending.  However, the Fed indicated that future increases might be needed if labor and commodity costs continue to rise.  This is the worst of all worlds from the stock market perspective – growth will slow, and may slow more.  Economists immediately lowered GDP projections over the next year from 3% to 2.5%.  Still, with world economic growth bubbling along in the plus 3% range, and with S&P 500 earnings expected to grow 9% over the next year, yield on the 10 year treasury hovering around 5%, the US stock market remains undervalued by 31%.

Energy Prices

Oil prices fluctuated in the mid $70’s/barrel over the last month.  Supplies in the US remain plentiful, but speculators worry about the Israeli/Hezbollah conflict spreading to Syria and Iran and disrupting deliveries of Middle East crude.  Meanwhile 8% of US production went off line earlier this week as BP announced widespread corrosion in a pipeline processing Alaskan oil.  US demand is slack now as refineries switch from gasoline to heating oil production.  However, another hurricane like Katrina hitting the Gulf Coast refinery region would push oil over $80 for sure.  Interestingly, plus $3.00 gasoline seems to have little or no effect on consumption, which is 2% higher than last summer.

Natural gas prices fluctuated widely over the last month.  Natural gas is used for both heating and electricity production.  Prices spiked on demand for extra electricity to power air conditioners across the US in July, but have since eased back with cooler temperatures.

Ethanol production continues to attract investor attention.  Companies operating in this industry are still speculative from an investors point of view, but Walmart recently announced plans to roll out sales of E85, which is 85% ethanol and 15% gasoline, at select Wal-Mart’s and Sam’s Clubs over the next several years.  Broader availability would increase consumers’ confidence in this alternative.

Read the entire commentary here.